MEXICO: GETTING HAMMERED

Takeaway:Domestic and international headwinds are weighing on Mexican capital markets and that’s not something that we see reversing anytime soon.

This note was originally published May 28, 2013 at 15:11 in Macro

SUMMARY BULLETS:

Mexican capital markets are getting hammered from both sides – domestically on political risks and internationally on rising duration risk – and that’s not something that we see reversing anytime soon – at least until President Nieto’s reform agenda gets firmly back on track. Using the yield on the 10Y US Treasury as a proxy for financial repression in the US, it’s no surprise to see that Mexican 10Y yields have a +0.85 positive correlation to their American counterparts on a trailing 3Y basis.

Additionally, with no trustworthy way of modeling intraparty and interparty political risk, we have deferred to our quantitative risk management signals, which have confirmed a TRADE & TREND breakdown in the Mexican equity market. We have interpreted that to mean there is a high probability of more political consternation ahead.

With super-sovereign yields backing up globally now (review our detailed thoughts HERE, HERE, HERE and HERE), it’s no surprise to see one of the favorite yield chasing plays of US and Japanese investors throughout recent years is getting tattooed. Moreover, with everything we now know about EM crises cycles (CLICK HERE for our 120+ page presentation), it’s getting a lot easier to spot these risks in real-time and reallocate assets before it’s too late.

We’ve obviously been the bulls on domestic equities and USD exposure in the YTD, but for those of you who must remain invested in emerging markets, we continue to like consumption-oriented markets like the Philippines, India and Indonesia in lieu of commodity/inflation oriented markets such as Russia, Brazil, South Africa and Peru. If you’re looking to play our thesis in the FX market, we continue to warn of material downside across the currencies of Latin American and African commodity producing nations.

Two weekends ago, National Action Party (PAN) Chairman Gustavo Madero decided against his party’s wishes to remove 45-year-old former Finance Minister Ernesto Cordero from his post as PAN Senate leader (24 of the PAN's 38 senators signed a letter in support of Cordero). The internal struggle atop the PAN, one of Mexico’s three main political parties, has accentuated the divide between PAN lawmakers willing to work with the ruling Institutional Revolutionary Party (PRI) and those who believe the party must mount a robust opposition to the galvanizing Pena Nieto in order to mitigate the risk becoming irrelevant (i.e. Cordero and the 24 senators that openly support him).

The key issue with this is that President Pena Nieto's PRI, which remains short of a majority in Mexican Congress, needs support from the conservative PAN to advance his economic reform agenda, which includes re-working the Mexican Constitution to overhaul state oil behemoth Pemex and to broaden the tax base. It would be hard to argue that President Nieto’s reform agenda has not been the primary driver of positive sentiment among international investors surrounding Mexico’s economic outlook in the YTD, so to the extent this creates a sustained rift within the PAN, you could see incremental selling pressure upon Mexican capital markets.

All that being said, some solace should be taken in the fact that Madero has openly stated that removing Cordero was merely an attempt to improve relationship between PAN party leaders and senators, insinuating that the move was unrelated to differences about party’s future in the “Pact For Mexico” alliance (i.e. the tri-party political vehicle responsible for streamlining economic reforms). At any rate, it’s tough to see how much of the reform agenda is permanently derailed by this act until the political dust settles, which, last month, included allegations of corruption upon PRI officials at the state level.

With no trustworthy way of modeling intraparty and interparty political risk, we have deferred to our quantitative risk management signals, which have confirmed a TRADE & TREND breakdown in the Mexican equity market. Specifically, we have interpreted that to mean there is a high probability of more political consternation ahead.

Since early last week, the Mexican political scene has been relatively quiet with no major developments regarding the now-shaky Pact For Mexico and President Nieto’s economic reform agenda. What has weighed on Mexican capital markets in recent days has been rising investor expectations that the Federal Reserve’s QE program is poised to be pared back at some point over the intermediate term.

Mexico, due to its proximity and economic integration with the US (as opposed to a recessionary Europe and structurally slower China; the US accounts for 80% of Mexican exports) has been a darling for yield-chasing capital during the Ben S. Bernanke financial repression era. As such, we’re really starting to see Mexican capital markets break down in recent weeks amid the recent backing up of global interest rates. Through yesterday’s close:

3M Implied Volatility on the USD/MXN increased +16.9% WoW and +24.4% MoM through yesterday’s closing price of 11.485 – the highest level since last SEP;

Yields on 2Y sovereign peso bonds are up +21bps WoW and 14bps MoM; and

Yields on 10Y sovereign peso bonds are up +39bps WoW and +68bps MoM.

Net-net, Mexican capital markets are getting hammered from both sides – domestically and internationally – and that’s not something that we see reversing anytime soon – at least until President Nieto’s reform agenda gets firmly back on track. Using the yield on the 10Y US Treasury as a proxy for financial repression in the US, it’s no surprise to see that Mexican 10Y yields have a +0.85 positive correlation to their American counterparts on a trailing 3Y basis.

With super-sovereign yields backing up globally now (review our detailed thoughts HERE, HERE, HERE and HERE), it’s no surprise to see one of the favorite yield chasing plays of US and Japanese investors throughout recent years is getting tattooed. Moreover, with everything we now know about EM crises cycles (CLICK HERE for our 120+ page presentation), it’s getting a lot easier to spot these risks in real-time and reallocate assets before it’s too late.

We’ve obviously been the bulls on domestic equities and USD exposure in the YTD, but for those of you who must remain invested in emerging markets, we continue to like consumption-oriented markets like the Philippines, India and Indonesia in lieu of commodity/inflation oriented markets such as Russia, Brazil, South Africa and Peru. If you’re looking to play our thesis in the FX market, we continue to warn of material downside across the currencies of Latin American and African commodity producing nations.

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